I am a Tax Partner in WithumSmith+Brown’s National Tax Service Group and the founding father of the firm's Aspen, Colorado office. I am a CPA licensed in Colorado and New Jersey, and hold a Masters in Taxation from the University of Denver. My specialty is corporate and partnership taxation, with an emphasis on complex mergers and acquisitions structuring. In the past year, I co-authored CCH's "CCH Expert Treatise Library: Corporations Filing Consolidated Returns," was awarded the Tax Adviser's "Best Article Award" for a piece titled "S Corporation Shareholder Compensation: How Much is Enough?" and was named to the CPA Practice Advisor's "40 Under 40."

In my free time, I enjoy driving around in a van with my dog Maci, solving mysteries. I have been known to finish the New York Times Sunday crossword puzzle in less than 7 minutes, only to go back and do it again using only synonyms. I invented wool, but am so modest I allow sheep to take the credit. Dabbling in the culinary arts, I have won every Chili Cook-Off I ever entered, and several I haven’t. Lastly, and perhaps most notably, I once sang the national anthem at a World Series baseball game, though I was not in the vicinity of the microphone at the time.

Capital Gains And The Fiscal Cliff Deal: How Does It Work?

Dear congressional staff writer responsible for the American Taxpayer Relief Act of 2012,

Look, I know you were in a tough spot. I recognize that while the entire world anxiously awaited a last-minute deal that would avert a fiscal disaster in the U.S., all of that pressure ultimately landed in your lap, as it was you who was responsible for converting the harried thoughts of opposing octogenarians into written law. I realize that as the hour grew late, it was you who was at the mercy of the changing winds of negotiation; forced to constantly add, retract and amend. And I appreciate that when the Senate is relentlessly hammering on you to produce the most anticipated piece of legislation in years so they can put it to a vote a mere three minutes later and mercifully end a 72-hour nightmare, it was you who was obligated to stay focused and construct clear language. I feel for you, I truly do.

But with all of that said, now that the dust has settled and a deal is in place, as a tax professional, I’ve got to be able to make some sense of this new legislation, and that ain’t always easy.

For example: mere hours after the deal was done, a reader asked me what on the surface, appeared to be a basic question:

The $450,000 threshold [at which both the 39.6% tax rate on ordinary income and the 20% rate on long-term capital gains kick in for a married couple filing jointly] is often phrased in terms of “earnings”. Do “earnings” include only ordinary income, or do they also include capital gains and other investment income. For example, if a married filing jointly taxpayer earned $350,000 in wages but had $200,000 in capital gains, what would your tax be?

Now, the first part of this question was fairly easy to address. While the thresholds for higher tax rates have often been referred to in terms of “earnings,” I explained that these thresholds are in fact driven by taxable income. To illustrate, if a single taxpayer had $500,000 in adjusted gross income and $150,000 of deductible itemized deductions and personal exemptions (after accounting for the PEASE and PEP limitations), his taxable income would be $350,000. And since the threshold for higher taxes for a single taxpayer is $400,000, none of his income would be taxed at either the new 39.6% rate on ordinary income or the 20% rate on long-term capital gains. Right? Right.

His second question, however, was very intriguing, and this is where I could use your help. Until the question was asked, I hadn’t given much (read: any) thought to how these higher taxes would apply to a taxpayer who had both ordinary income and long-term capital gains that separately did not exceed the applicable threshold for higher taxes, but did when combined. Stated in a simpler manner, what was the “ordering rule” of the new law?

The impact is meaningful. Consider the following simple hypothetical:

Taxpayer: Mickey and Mallory Knox

Filing Status: Married filing jointly

Ordinary income: $350,000

Long-term capital gains: $200,000

Taxable income after deductions: $500,000

As a married couple, the threshold for higher taxes under the fiscal cliff deal is $450,000. This raises a number of questions with regards to the treatment of the capital gain:

Since taxable income exceeds the threshold, is all of the capital gain taxed at 20%?

If not, does the capital gain get applied to the threshold first, so that it is all taxed at 15%?

Or does the ordinary income get applied to the threshold first, so that none of the ordinary income is subject to the new 39.6% rate, and a portion of the capital gain is taxed at 15%, and the remainder taxed at 20%?

While unrealistic to expect, I was hopeful that the answer was neatly tucked away within the body of your new law. Sadly, this wasn’t the case. Rather, to reach a conclusion, I had to take the amendments to the existing law found in your new legislation and apply them to the current statute. And that’s where things got messy.

Now granted, Section 1(h), which generally governs the interplay between the tax on capital gains and ordinary income was no picnic before the fiscal cliff deal – with its abundance of seemingly-interchangeable but differently-defined terms, endless greater of/lesser of determinations, and five tiers of potentially preferential rates on capital gains – but the language in the new law did old Section 1(h) no favors. Like the existing law, the changes to the statute reads as cleanly as Chinese arithmetic, but I think I’ve got it figured out.

Section 1(h) requires a taxpayer with both ordinary income and long-term capital gains to endure a multi-step process in applying tax rates. Here’s how I applied the steps; feel free to check my work.

Step 1: Determine the portion of taxable income that will be subject to ordinary rates using the graduated rate tables: This is the greater of:

a. The amount of income taxed at rates below 25% (approximately $72,500 for MFJ in 2013), or

b. Taxable income less adjusted capital gain. In short, adjusted capital gain is your net long-term capital gain less certain gains subject to a different rate, such as 25% on certain depreciation recapture upon the sale of real estate or 28% on gain from the sale of collectibles. In our example, all of our net capital gain is adjusted capital gain, so the formula is $500,000 – $200,000 = $300,000

As a result of this lesser of/greater of analysis, $300,000 of the $500,000 of taxable income is taxed at ordinary income rates, subject to the graduated rate tables. But here’s the takeaway point: notice that even though this taxpayer has taxable income in excess of $450,000, they will not pay any tax at the new 39.6% rate. This is because their ordinary income, when subjected to the tax rate tables, will not exceed the $450,000 threshold.

Step 2: Determine the portion of long-term capital gains subject to a 0% rate. The fiscal cliff deal extended the 0% rate on long-term capital gains for taxpayers who would otherwise be in the 10% or 15% tax bracket. The amount of capital gains subject to the 0% rate is the lesser of:

Net capital gain of $200,000, and

The top of the 15% bracket ($72,500) reduced by (taxable income less adjusted capital gain, or $500,000 – $200,000). So, $72,500 – $300,000 = $0.

Thus, none of the capital gain is taxed at the preferential 0% rate, which is what you would expect, since the taxpayer had taxable income of $500,000.

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Tony — Your calculations are all correct. That is the way the law works. The “ordering rule” you requested is already in the existing law — the law you used to do this calculation. The long-hand math you’ve done is a drawn out way of saying that capital gains are part of your income. Your Step 3 is the “ordering rule”. This same issue arose with the 0% rate – the JCT gave the following example at one point: Let’s say you are a married couple, filing jointly with a taxable income of $65,000. If you realize $10,000 in long term capital gains, the first $5,700 of the gains will qualify for the zero percent rate. However, the remaining $4,300 will be taxed at the regular long term capital gain rate of 15%.

What about the AMT? Has that been changed? Maybe you wouldnt mind helping me out here, as I am having great anxiety over figuring this out: We make (mfj) 250k. We had a long term cap gain from the sale of equity in a company we work for of 800,000. It was an 83b election. We have a carry forward of 180,000 from a long term capital LOSS (I’ve been deducting about 3k every year). Never before been subject to amt and now acct. says I will be. Other deductions are normal minimal stuff. (200,000 home mortgage). We just paid estimates to NJ and the fed of 69 and 115K. Any thoughts for me to know if I fall into amt (enough info?) or what my taxes will be? – Thanks so much.

It hasnt really been mentioned in the news much, but some people are reporting the “carried interest” rule remained untouched in the current fiscal cliff deal. I dont see how this is the case though. While that loophole might not have been closed the flow through of the gain to the personal return of the people receiving might be subject to new higher cap gains tax and the medicare surtax (if income is high enough). So that makes the new rate 23.8? or over a 50% plus increase for the wealthy hedge fund guys. What do you think?

The carried interest was not addressed in any of the direct manners President Obama has previously proposed, such as converting all flow through income of a holder of a carried interest into ordinary income, regardless of its character at the entity level. And while the increase of the maximum capital gain rate from 15% to 23.8% will increase the tax rate of these holders, keep in mind, the top ordinary income rate has similarly increased, from 35% to 39.6% (43.4% in certain cases). So while the pure tax bill of many carried interest holders has increased, they are still greatly benefitting from a near 20% arbitrage between the rate they will pay on capital gains versus what they would be paying if the carried interest income were taxed as capital gains.

If in the above scenario, the qualified dividends amount was $200,000 instead of Long term Cag gains (hence 0 in this case), and everything else remains the same, will the taxes payable be the same as above? In the second scenario, if there was qualified dividend income of $200,000 and long term cap gains of $200,000, how would the tax calculation work out. No other earned income and deductions are 0. Thanks for your advice.

Siva, qualified dividends get the same preferential treatment as long term capital gains, so yes, the tax liablity would be the same. The taxpayer would pay tax at $300,000 at ordinary rates, $150,000 at 15%, and $50,000 at 20%. The entire $200,000 of qualified diviends would then be taxed at an extra 3.8% under the obamacare tax.

In your second situation, if a taxpayer had $200K of cap gains and $200K of qualified dividends and no other income, the $400K of investment income would be taxed at 15%, since taxable income does not exceed the $450,000/$400,000 thresholds. Then — assuming the taxpayer is married — $150K of the investment income ($400K – $250K) would be taxed at an extra 3.8% under the obamacare tax.

Thanks for the article, Tony. Let’s say in the second scenario in Siva’s question, a person has $0 ordinary income but over $450k (MFJ) in long-term capital gains…is the first $450k taxed at 15% and the remaining gain taxed at 20%? Another example would be a person with $0 ordinary income who sells a business in 2013 for a long-term gain of $2 Million. Would the first $450k be at 15% and the remaining $1.55M be at 20%? It would seem, based on your article, that whether the income is wages, dividends, capital gains, etc., the capital gains tax would be tiered and there would be no circumstance where a long-term gain exceeding $450k (MFJ) would be taxed entirely at 15%. Is this correct? Any clarification is appreciated, as I have seen the new law explained differently, where only ordinary income is used to figure out whether a person’s capital gains fall under the 15% rate or 20% rate. Thank you!

Emilie, if you had $0 of ordinary income but over $450K (MFJ) in LTCG, and assuming that it constituted all of their taxable income, then yes, under Section 1(h), the first $450,000 of LTCG would be taxed at 15% and only the excess would be taxed at 20%. Same with your second scenario: if no ordinary income but $2M of LTCG, the first $450K would be taxed at 15%, the remainder at 20%.

In no scenario could LTCG in excess of $450K be taxed ALL at 15%. The amount in excess of $450,000 (assuming no ordinary income) would be taxed at 20%. In fact, if the taxpayer’s ordinary income exceeds $450,000, ALL of the LTCG would be taxed at 20%.